In Part I we saw that readily available evidence shows clearly that economic performance in the free-market era that began around 1980 was already poor, even before the disaster of the Global Financial Crisis. Here we look at the theory that underlies the free-market rhetoric, the so-called neoclassical theory.
This theory is an abstraction well over 100 years old, from a time when the idea of a clockwork universe still prevailed in science. To maintain mathematical tractability, the theory makes simplifying assumptions about people and firms. It assumes we are narrowly rational and that we can foretell the future. It assumes we have access to all relevant information for free, and can assimilate its implications immediately. It assumes we are brute materialists. It assumes there are no social interactions. It assumes there is a limit to economies of scale, based on constraints peasant farmers used to face.
With enough assumptions like this, you can deduce, using clever mathematics, that a market will balance all supplies with all demands and the economic system will come to an equilibrium. This “general equilibrium” turns out to be the most efficient conceivable configuration of this abstract system, in the sense of producing the most goods from the least inputs of human effort.
This abstraction has proven extremely seductive to rich people, because it seems to say they should keep making money as fast as they can, and to the mathematically inclined, because they can play endless games with the theory.
However it is absurd to suggest that this abstract theory has any relevance to real economies. If any one of those assumptions is violated you predict very different behaviour of the economy. If the behaviour is very different then the central theoretical conclusion, that a free-market economy comes to an optimal equilibrium, is lost. Lost with it is the basis for all the free-market rhetoric.
For example if information is incomplete or delayed then feedback is too weak to restore equilibrium. If there are social interactions then there are phenomena like herd behaviour that destroy equilibrium. If we all cannot foretell the future then feedbacks are erratic and so is the system’s behaviour. If economies of scale apply up to very large firms, like Microsoft or McDonalds, then one or a few firms can grow exponentially at the expense of others, and yield oligopoly or monopoly, which is not optimal. And of course if we are more than brute materialists then perhaps we want more out of life than ever more stuff, inequitably distributed.
Abstract theories may be entertaining, but if you want them to be the basis of a science you must compare them with observations of real economies. Manifestly, human beings cannot foretell the future. Our decisions are often governed by reactions tuned to the survival of hunter-gatherers but not always sensible (“rational”) in modern circumstances. Herd behaviours can be observed in fashion and the financial markets, and are well-known to the marketing industry, which exploits them intensively. Many industries are dominated globally by a handful of firms. New technologies frequently displace older technologies, with a new group of firms bubbling up exponentially and taking over, upsetting equilibrium. All of these well-known features of modern economies contradict the theory.
Most tellingly, a near-equilibrium system should only exhibit abrupt change when physical circumstances change abruptly, as in a natural disaster or a war. However there have been many abrupt falls in markets without any external provocation, as was recounted in Part I. Thus, for example, in 1987 stock markets fell thirty or forty percent in a day, though thirty percent of the world’s factories had not been bombed overnight. These sudden falls were driven by the internal dynamics of the system, and are symptomatic of dysfunctional internal interactions.
In science, the purpose of a theory is to provide guidance on the behaviour of the observable world. The neoclassical theory bears no useful resemblance, in its founding assumptions and in its central prediction of equilibrium, to observable modern economies. To apply such a deficient theory is to practice pseudo-science: it is an activity that maintains the trappings of science, but that fails the central test of science, that it is a useful guide to the behaviour of observable economies.
The neoclassical theory was a heroic attempt for its time in the late nineteenth century. However to an experienced real scientist it is laughable that such a deficient theory has retained currency for over a century.
The clear conclusion from Parts I and II is that free-market economics has no basis in theory or in practice for its claim that free markets are the best way to organise an economy. There is no assurance that free markets in the real world will deliver an optimal, or even desirable, result. The retarded performance of the past three decades, culminating in a market crash, bears out the falsity of the free-market fundamentalists’ claims.
Nor, to be clear where this is not going, is socialism the inevitable alternative. There are good reasons why socialism is also insufficient. The relative success of the post-war era suggests, on the other hand, that carefully managed markets offer a better basis for an economy. We can probably do even better than such a social-democratic approach, but that is another story.